Parasitic Capitalism

–Well that was pretty much how Murray called it. The market rallied on the rumour of a US debt deal. And now it’s selling off on the news. Murray ducked in the office the morning to discuss, then headed to his desk and promptly sent out a short-sell recommendation on four rather blue Aussie blue chips. If you want to see the analysis that prompted the trades, watch his YouTube video from last Friday.

–Why is the market selling off on the news? Two reasons, as far as we can reckon. The deal is a big fat nothing burger of a bad joke, to mix metaphors. It raises the US debt ceiling by $2.1 trillion over the next two years—enough to get us through the next Presidential election. The $2.4 trillion in spending cuts and “savings” are to be phased in over 10 years.

–Ten years is plenty of time for Congress to find ways around spending cuts. The net result of the deal is that the US will have around $17 trillion in debt in a few short years. You can bet your worthless dollar on that. Defence spending will be cut, which is a good start. But spending on entitlements like Medicare, Medicaid, and Social Security won’t be touched.

–In short, the United States remains a nation that refuses to live within its means. Its political leadership is either economically illiterate, in denial, or spineless, or some combination of all three. This deal makes it a virtual certainty that the credit ratings agencies will downgrade US sovereign debt. And that’s when the global fireworks will start going off.

–The downgrading of US sovereign debt is a big issue. We’ll get to it in just a moment. But first, don’t expect another round of quantitative easing to come flooding in and save the stock market. As we showed yesterday, the Australian share market (which has essentially been flat for five years) depends on expanding global liquidity to go up.

–But inflation is already uncomfortably high in Australia—that’s what may prompt the Reserve Bank to raise interest rates when it meets later today. Inflation is also rising in China. The US Fed is unlikely to do anything that looks like it’s going to lead to rising consumer prices.

–In other words, the political and economic climates make it very hard for QE III to gain any traction. A good old-fashioned stock market crash is not enough to justify more intervention in financial markets when the previous interventions led to inflation in food and fuel prices. The Fed is stuck.

–So what will happen when the US government is downgraded by the ratings agencies? Well, that’s the multi-trillion-dollar question, isn’t it? There are many pension funds, mutual funds, sovereign wealth funds, and probably Australian super funds and local councils that have exposure to US debt. By law, some of those who own US debt will be forced to sell it if it no longer has a AAA rating.

–If you’re a forced seller of US government debt, and you owned it because you thought it was a safe, sound, long-term repository for your cash, what would you buy instead? Used cars? Used gold? Australian government bonds?

–It will be interesting to watch the action in Aussie government bonds. As we noted last month, the volume on credit default swaps related to the Aussie sovereign debt has been on the up. Betting on an Aussie government default has become a bit of proxy bet on Australia’s banks. The logic of the trade is that if the housing market blows up, a crisis in any one of the Big Four banks will force the Aussie government to use its triple-A credit rating to bail them out.

–That’s an interesting trade. It’s consistent with what’s happened in other countries where the housing markets have blown up and taken the banking sectors with them. That forced the government to assume the liabilities of the banks, which in turn put enormous pressure on government finances, driving up the cost of insuring against default, and increasing the probability of default.

–CMA uses credit default swap prices to construct what it calls a cumulative probability of default on corporate and government debt (CPD). Its most recent data suggest there’s a 76% chance of Greece defaulting on its government debt within the next five years. For Portugal it’s 55%. And for Ireland it’s 50%.

–Even after the debt ceiling brouhaha in the US, the CDP is just 4.26%. That’s actually lower than the most recent Australian CPD figure of 5%. You might wonder how it’s possible that a nation with a $14 trillion fiscal deficit that’s nearly 100% of GDP and growing can have a lower probability of defaulting than a nation with a fiscal deficit that’s about 7% of GDP.

–Either the bond markets are dead wrong, or they’re telling you that at a systemic level, Australia’s government faces the same risks as the US government—bearing the burden for a bust in the credit (especially housing) markets. There are two differences. One, Australia’s housing bubble hasn’t burst yet. And two, Australia does not print the world’s reserve currency.

–The US can print the same money it borrows in. It doesn’t ever have to default as long as it retains this privilege. But its creditors now know that the US can’t be trusted. This is why America’s trusted friend and car pool partner in space, Vladimir Putin, has said Americans, “Are living like parasites off the global economy and their monopoly of the dollar.”

–Them used to be fightin’ words. But now they are just words that confirm that we have come the end of the dollar’s reign as the world’s reserve currency. This is pushing up yields on government bonds. And in the long run, it will push up the price of precious metals too, as a reserve monetary asset (money).

–What it will do to stocks is not quite as clear. But our prediction is that you’ll see a whole lot of sideways action. Without additional liquidity surges to push indexes higher, and with manufacturing activity across the world showing a slowing economy, stocks are facing a double whammy. Wham. Wham.

Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

DD: “…economically illiterate, in denial, or spineless…” (?) For ‘spineless’ substitute ‘politically aware’. What politician, of any colour or persuasion, in any country in the world, would want to be at the wheel when the ship sank? Note the difference between ‘aware’ and ‘astute’ here. A highly gifted, very astute politician (surrounded by even more gifted economists*) _might_ just be able to drag the US through this endless mire, but Americans utterly unused to penury, would never thank this leader. Perhaps in half-a-century, they might… . Travelling in Alaska right now, we get US Google ads instead of West Aussie… Read more »

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